ALIGN TECHNOLOGY INC

Income Taxes

The U.S. Tax Cuts and Jobs Act (the “TCJA”) was enacted into law on December 22, 2017, and impacted our effective tax rate for the year ended December 31, 2017. The TCJA made significant changes to the Internal Revenue Code, including, but not limited to, a corporate tax rate decrease from 35% to 21% effective for tax years beginning after December 31, 2017, the transition of U.S international taxation from a worldwide tax system to a territorial system, and a one-time transition tax on the mandatory deemed repatriation of cumulative foreign earnings as of December 31, 2017.

We have estimated the impact of the TCJA and recorded $84.3 million of additional income tax expense in the fourth quarter of 2017, the period in which the legislation was enacted. The components of this expense are as follows:

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We recorded a provisional tax amount of $73.9 million for the transition tax liability. We have not yet completed the calculation of the total post-1986 foreign Earnings and Profits ("E&P") and the income tax pools for all foreign subsidiaries. Further, the transition tax is based in part on the amount of those earnings held in cash and other specified assets. This amount may change when we finalize the calculation of post-1986 foreign E&P previously deferred from U.S. federal taxation and the amounts held in cash or other specified assets. In addition, further interpretations from U.S. federal and state governments and regulatory organizations may change the provisional liability or the accounting treatment of the provisional liability.

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We recorded a provisional tax amount of $10.4 million to remeasure certain deferred tax assets and liabilities as a result of the enactment of the Act. We are still analyzing certain aspects of the TCJA and refining the estimate of the expected reversal of the deferred tax balances. The TCJA can potentially affect the measurement of these balances or potentially give rise to new deferred tax amounts.

The TCJA also includes provisions for certain foreign-sourced earnings referred to as Global Intangible Low-Taxed Income (“GILTI”), which impose a tax on foreign income in excess of a deemed return on tangible assets of foreign corporations. FASB guidance issued in January 2018 allows companies to make an accounting policy election to either (i) account for GILTI as a component of tax expense in the period in which the tax is incurred (the “period cost method”), or (ii) account for GILTI in the measurement of deferred taxes (the “deferred method”). Because of the complexity of the new provisions, we are continuing to evaluate the accounting impact under GAAP, and will make an election once this analysis has been completed.

Net income before provision for income taxes and equity in losses of investee consists of the following (in thousands):



	Year ended December 31,
	2017		2016		2015
Domestic	$	123,696	$	118,871	$	87,803
Foreign	241,103		123,695		98,298
Net income before provision for income taxes and equity in losses of investee	$	364,799	$	242,566	$	186,101

The provision for income taxes consists of the following (in thousands):



	Year Ended December 31,
	2017		2016			2015
Federal
Current	$	91,214	$	40,235		$	28,596
Deferred	15,724		24,794			6,679
	106,938		65,029			35,275
State
Current	2,580		2,603			3,271
Deferred	2,677		2,636			(703		)
	5,257		5,239			2,568
Foreign
Current	15,285		8,964			4,305
Deferred	2,682		(28,032		)	(67		)
	17,967		(19,068		)	4,238
Provision for income taxes	$	130,162	$	51,200		$	42,081

The differences between income taxes using the federal statutory income tax rate of 35% and our effective tax rate are as follows:



	Year Ended December 31,
	2017		2016		2015
U.S. federal statutory income tax rate	35.0	%	35.0	%	35.0	%
State income taxes, net of federal tax benefit	1.4		2.1		1.5
Impact of U.S. Tax Cuts and Jobs Act	23.1		—		—
Impact of differences in foreign tax rates	(18.0	)	(6.3	)	(16.2	)
Valuation allowance release for Israel	—		(12.9	)	—
Stock-based compensation	(6.3	)	1.2		1.6
Other items not individually material	0.5		2.0		0.7
	35.7	%	21.1	%	22.6	%

As of December 31, 2017, undistributed earnings of the company totaled $606.5 million. We reassessed our capital needs and investment strategy with regard to the indefinite reinvestment of the undistributed earnings from certain of our foreign subsidiaries as a result of the one-time transition tax on cumulative foreign earnings under the TCJA. During the fourth quarter of 2017, we determined that approximately $591.9 million of the total undistributed foreign earnings are no longer be considered to be indefinitely reinvested outside the U.S. As a result, we have recorded a deferred tax liability of approximately $3.3 million, which represents the provisional amount of U.S. state income taxes that would be due in the event these foreign earnings are distributed. The remaining amount of undistributed foreign earnings of approximately $14.7 million continues to be indefinitely reinvested in our international operations. Since U.S. federal income tax has already been provided under the provisions of the TCJA, the additional tax impact of the distribution of such foreign earnings to the United States parent would be limited to U.S. state income and withholding taxes and is not significant.

On July 1, 2016, we implemented a new international corporate structure. This changed the structure of our international procurement and sales operations, as well as realigned the ownership and use of intellectual property among our wholly-owned subsidiaries. We continue to anticipate that an increasing percentage of our consolidated pre-tax income will be derived from, and reinvested in our foreign operations. We believe that income taxed in certain foreign jurisdictions at a lower rate relative to the U.S. federal statutory rate will have a beneficial impact on our worldwide effective tax rate over time. Although the license of intellectual property rights between consolidated entities did not result in any gain in the consolidated financial statements, the Company generated taxable income in certain jurisdictions in 2016 resulting in a tax expense of $34.3 million. Additionally, as a result of the restructuring, we reassessed the need for a valuation allowance against our deferred tax assets considering all available evidence. Given the current earnings and anticipated future earnings of our subsidiary in Israel, we concluded that we have sufficient positive evidence to release the valuation allowance against our Israel operating loss carryforwards of $31.4 million, which resulted in an income tax benefit in this period of the same amount.

In June 2017, the Costa Rica Ministry of Foreign Trade, an agency of the Government of Costa Rica, granted an extension of certain income tax incentives for an additional twelve year period. Under these incentives, all of the income in Costa Rica is subject to a reduced tax rate. In order to receive the benefit of these incentives, we must hire a specified number of employees and maintain certain minimum levels of fixed asset investment in Costa Rica. If we do not fulfill these conditions for any reason, our incentive could lapse, and our income in Costa Rica would be subject to taxation at higher rates, which could have a negative impact on our operating results. The Costa Rica corporate income tax rate that would apply, absent the incentives, is 30% for 2017, 2016 and 2015. As a result of these incentives, our income taxes were reduced by $1.8 million, $19.1 million and $32.7 million in the year ended December 31, 2017, 2016 and 2015, respectively, representing a benefit to diluted net income per share of $0.02, $0.23 and $0.40 in the year ended December 31, 2017, 2016 and 2015, respectively.

As of December 31, 2017 and 2016, the significant components of our deferred tax assets and liabilities are (in thousands):



	Year Ended December 31,
	2017			2016
Deferred tax assets:
Net operating loss and capital loss carryforwards	$	24,971		$	25,445
Reserves and accruals	12,547			22,954
Stock-based compensation	10,074			16,399
Deferred revenue	10,811			13,975
Net translation losses	1,928			1,634
Credit carryforwards	792			679
	61,123			81,086
Deferred tax liabilities:
Depreciation and amortization	7,522			12,034
Unremitted foreign earnings	3,305			—
Prepaid expenses	751			969
	11,578			13,003
Net deferred tax assets before valuation allowance	49,545			68,083
Valuation allowance	(278		)	(256		)
Net deferred tax assets	$	49,267		$	67,827

The total valuation allowance as of December 31, 2017 was not material. During the year ended December 31, 2017, the valuation allowance increased by a nominal amount which was mainly related to foreign currency translation adjustments.

As of December 31, 2017, we have fully utilized California net operating loss carryforwards. As of December 31, 2017, we have California research credit carryforwards of approximately $4.1 million which can be carried forward indefinitely. In addition, we have foreign net operating loss carryforwards of approximately $104.7 million, the majority of which can be carried forward indefinitely, and a minor portion of which, if not utilized, will expire beginning in 2027.

In the event of a change in ownership, as defined under federal and state tax laws, our tax credit carryforwards may be subject to annual limitations. The annual limitations may result in the expiration of the tax credit carryforwards before utilization.

The changes in the balance of gross unrecognized tax benefits, which exclude interest and penalties, for the year ended December 31, 2017, 2016 and 2015, are as follows (in thousands):



Unrecognized tax benefit as of December 31, 2014	$	33,067
Tax positions related to current year:
Additions for uncertain tax positions	6,346
Unrecognized tax benefit as of December 31, 2015	39,413
Tax positions related to current year:
Additions for uncertain tax positions	6,971
Unrecognized tax benefit as of December 31, 2016	46,384
Tax positions related to current year:
Additions for uncertain tax positions	1,819
Tax positions related to prior year:
Additions for uncertain tax positions	1,809
Decreases for uncertain tax positions	(826		)
Settlements with tax authorities	(1,527		)
Reductions due to lapse of applicable statute of limitations	(3		)
Unrecognized tax benefit as of December 31, 2017	$	47,656

As of December 31, 2017, $39.8 million of our unrecognized tax benefits would impact our effective tax rate if recognized.

We have elected to recognize interest and penalties related to unrecognized tax benefits as a component of income taxes. For the year ended December 31, 2017 and 2016, interest and penalties included in tax expense was $0.8 million and $1.4 million, respectively. Our total interest and penalties accrued as of December 31, 2017 and 2016 was $2.9 million and $2.1 million, respectively. We do not expect any significant changes to the amount of unrecognized tax benefit within the next twelve months.

We file U.S. federal, U.S. state, and non-U.S. income tax returns. Our major tax jurisdictions are U.S. federal and the state of California. For U.S. federal and state tax returns, we are no longer subject to tax examinations for years before 2000. With few exceptions, we are no longer subject to examination by foreign tax authorities for years before 2010.